Written by Derryl Hermanutz

<< Part 1: How Banks Create Money And Why Governments Should Too

<< Part 2: How Banks Create Money And Why Governments Should Too

<< Part 3: How Banks Create Money And Why Governments Should Too

Debt-Based Money

Commercial banks do not lend out money they already have and do not lend out their depositors' account balances. Every bank loan and bond purchase is "funded" by the bank's creation of brand new money - a new bank deposit: a new spendable bank deposit account balance. That's where the deposit account money supply "comes from" - it is created by commercial banks.

From Modern Money Mechanics: A Workbook on Bank Reserves and Deposit Expansion, Federal Reserve Bank of Chicago (first published 1961; last updated 1994):

"The purpose of this booklet is to describe the basic process of money creation in a "fractional reserve" banking system. The approach taken illustrates the changes in bank balance sheets that occur when deposits in banks change as a result of monetary actions by the Federal Reserve System -- the central bank of the United States. ...

What is money? If money is viewed simply as a tool used to facilitate transactions, only those media that are readily accepted in exchange for goods, services and other assets need to be considered transactions money."

From Economics of the Canadian Financial System: Theory, Policy & Institutions by Shearer, Chant, Bond, Third Edition (1995); from a section titled, Banks and Deposit Creation, p. 565; emphasis in original:

"...the liabilities of banks and other depository institutions have the peculiar characteristic that they are money. When these intermediaries purchase earning assets such as bank loans and promissory notes, they pay for them by issuing their own liabilities. There is no question of the public's accepting the liabilities of depository institutions... The public accepts them because they are accepted as money by others.

Thus, by increasing their earning assets, these institutions at the same time add to the supply of money. The creation of deposits by depository institutions to make loans or acquire securities represents in each case the creation of new deposits. We are now in a position to express our first fundamental principle of deposit creation by depository institutions.

Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit."

Commercial banks create new bank deposits when banks make loans to private-sector borrowers; and when banks purchase securities from government borrowers.

"Securities" are interest-bearing Treasury securities: government-issued bills, notes, and bonds; which are interest-bearing repayable government bond debts. Governments issue bond debts to borrow money that is created by commercial banks.

"Bank loans" and "promissory notes" are interest-bearing private sector debts. People and businesses issue loan account debts to borrow money that is created by commercial banks.

"Through the creation of a deposit by making a loan or acquiring a security, a depository institution increases the money supply by the amount of the created deposit."

Private sector debtors issue interest-bearing loan account debts: mortgage loan debts, student loan debts, car loan debts, credit card debts, home equity loan debts, small business loan debts, corporate loan debts, institutional loan debts, etc, etc.

Government debtors issue interest-bearing Treasury bills, notes, bonds: government bond debts.

And commercial banks issue their own debts - deposit liability debts: bank deposits - to "pay for" the banks' purchases of those new interest-earning debt assets.

Banks use debtors' interest-bearing debts as the banks' interest-earning assets.

We use commercial banks' deposit liability debts as our deposit account money supply.

Debtors and their creditor banks create the deposit account money supply - and the loan account and bond debts owed to commercial banks - by expanding banks' balances sheets with linked pairs of banks' new deposit liabilities (the debtor's new spendable, cashable deposit account credit balance) and the banks' equal new interest-earning assets (the debtor's new interest-bearing, repayable loan account debt balance or bond debt).

Debtors pay the new credit balances to payees within the bank-operated payments system.

But payees were not paid legal tender money (central bank-issued currency).

Payees were paid credit-debt money: commercial bank-issued bank deposits.

Bank deposits are credit-debt instruments that commercial banks create to fund their bank loans and bond purchases.

"We use commercial banks' deposit liability debts as our deposit account money supply."

Our deposit account credit balances are our banks' deposit liability debt balances.

We use commercial banks' deposit liability debts as our deposit account money supply.

Payees accept payment in commercial banks' debts as payment "in money", because virtually everybody else also accepts bank deposits as money. And because, as long as the deposit-issuing banks remain liquid and solvent, banks' deposit liability debts "work" as a very secure and convenient form of digital/electronic "money in the bank".

Virtually all payments from buyers to sellers in the global economy are conducted by banks debiting payer account balances and crediting payee account balances within the globally integrated bank-operated electronic payments system. The money - that is being paid by buyers (spent) and paid to sellers (earned) - is bank deposits: electronic numbers in banking system accounting software.

The cash money supply - banknotes and coins in our pockets, outside the banking system - is only about 2-5% of the total money supply. The deposit account money supply in our bank accounts is 95-98% of the total money supply.

We use bank deposits as:

• our main form of payments money (demand deposits: people's checking account balances and businesses' current account balances that we use as our "paying and getting paid bank deposits" accounts);

• our main form of earned and accumulated financial wealth and security (savings account balances); and

• our main form of investible capital (shadow bank cash account balances, that are originally created when we transfer balances out of our commercial bank deposit accounts into our shadow bank cash accounts).

We use commercial banks' debts as our main form of "money".

When the banking system fails, commercial banks default on paying their deposit liability debts, and the bank-issued credit-debt money no longer works as "money".

"The deposit account money supply in our bank accounts is 95-98% of the total money supply."

This is a catastrophic problem for the people, businesses, and governments of the world who use bank account money as our main form of money.

What is "debt-based" money?

Bank account money - deposit account balances and reserve account balances - exists as linked pairs of creditor-assets/debtor-liabilities on banks' balance sheets.

Central banks issue reserve account balances (central bank reserves) in commercial banks' reserve accounts. A commercial bank's reserve account balance is the commercial bank's collectable money asset that is owed as the central bank's payable money liability.

Commercial banks issue deposit account balances (bank deposits) in debtors' bank deposit accounts.

Debtors pay the new bank deposits to payees. Payees are commercial banks' deposit account customers.

A payee's bank deposit account balance is the customer's collectable money asset (credit balance) that is owed as the bank's payable money liability (debt balance).

Banks' money liabilities - commercial banks' deposit liabilities; the central bank's reserve liabilities - are payable in money.

Currency - physical banknotes and coins - is "the money": legal tender; legal money.

Banks' liabilities are payable in legal tender cash money.

The central bank issues the money: the banknotes. *

And the central bank issues the non-defaultable money assets to commercial banks: reserve account balances.

The central bank can never run out of money to pay the reserve liability debts it owes to its commercial bank reserve account customers: because if the central bank is running low on cash money it simply orders more banknotes from the Printer. The central bank is like a 100% reserve bank, whose reserve liabilities are 100% backed by the central bank's power to print the legal tender currency.

The central bank is unlike the "fractional reserve" commercial banks who can and do run out of money assets (reserve account balances) and money (vault cash) to pay their deposit liability debts.

Our deposit account credit balances are our banks' deposit liability debt balances.

The credits are collectable by the customer, and the debts are payable by the bank, in cash money.

Commercial banks are still legally liable to cashout our deposit account credit balances - pay their deposit liability debts in cash money - "on demand".

Commercial banks pay their deposit liability debts in legal tender money when we make cash withdrawals and pay with debits to our bank deposit account balances.

"The central bank can never run out of money to pay the reserve liability debts it owes"

The debit reduced our deposit account credit balance, which simultaneously and equally reduced the bank's deposit liability debt balance: because our credit balance and the bank's debt balance is the same credit-debt financial instrument (bank deposit) as seen from opposite sides of the bank's creditorassets/debtor-liabilities balance sheet.

When we cashout our bank account balance: the bank debits our balance to $0, and pays out our former balance amount in cash money. Our deposit account credit balance has been debited (subtracted) out of existence. We no longer have a credit balance in our bank account; and the bank no longer owes us a deposit liability debt. We have collected our collectable money asset (deposit account credit balance); the bank has paid its payable money liability (deposit liability debt balance); and we now have the legal tender money (banknotes) in our pocket.

Commercial banks buy currency from the central bank and pay with debits to their reserve account balances.

A commercial bank's reserve account balance - plus the cash money the bank has in its vault and cash drawers and ATMs (vault cash) - are the commercial bank's money assets that the bank spends when it pays its money liabilities: the bank's deposit liability debts owed to its deposit account creditors - the payees who accepted payment in commercial banks' debts (bank deposits) as payment "in money".

Commercial banks spend their money assets (reserve account balances) settling our payments system payments of bank deposits to payees at different banks. And commercial banks spend their reserve account balance buying currency from the central bank to get vault cash, so the banks can pay their deposit liability debts in cash money.

But "fractional reserve" banks only have enough money assets (reserve account balances) and money (vault cash) to pay a fraction of the deposit liability debts the banks owe to their deposit account creditors: the payees who now have all the credit balances in our bank deposit accounts.

Liquidity failure

When banks suffer liquidity failure - when banks run out of reserve account balances and vault cash - our deposit account credit balances no longer "work" as spendable, cashable "money in the bank".

We can't spend our deposit account balance by check, online banking or debit card because our illiquid bank has an insufficient reserve account balance (NSF) for the central bank to debit to settle the payment. So our payment attempts fail. Our deposit account is not debited, and the payee's deposit account is not credited, with the payment. The credit balance is still "in" our bank deposit account, but we can't spend it.

"central banks can easily prevent banking system liquidity failure by typing more numbers"

We can't cashout our credit balance for payment in the bank's vault cash because our illiquid bank has no cash money "in" its vault or cash drawers or ATMs, and has no reserve account balance to debit to buy more currency from the central bank.

When banks suffer liquidity failure our deposit account credit balances become our banks' unpayable deposit liability debt balances.

Liquidity is provided by money that is created "out of nothing" by banks

But "liquidity" is just "money"; and commercial banks' liquidity is their reserve account balances and vault cash - both of which are created by the central bank. So central banks can easily prevent banking system liquidity failure by typing more numbers (central bank reserves) into the Credits column of commercial banks' reserve accounts; then debiting the new reserve account balances when commercial banks buy legal tender currency to get vault cash from the central bank.

Banking system failure is a policy choice; not an inevitable feature of monetary and financial reality.

For the same reasons, the mass debtor defaults that cause banking system failure are also a policy choice.

"Banking system failure is a policy choice; not an inevitable feature of monetary and financial reality."

Governments and monetary policymakers could choose to prevent the debtor defaults by restoring liquidity to the banks' debtors, by typing numbers into the Credits column of people's bank deposit account balances, which the banks could then debit to make the debtors' otherwise unpayable bank loan payments. This is the "debt-free Money Income" policy choice that I described in Part 3.

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* [Banknotes and coins are both legal tender money.

Before the modern era of central-commercial banking, commercial banks used to print their own paper banknotes. Now all banknotes are central bank banknotes: e.g. Federal Reserve Notes (US$ dollars); Bank of England Notes (GBR£ pounds); European Central Bank Notes (EUR€ euros); Bank of Japan Notes (JPY¥ yen); People's Bank of China Notes (CNY¥ yuan); etc.

In some countries - like the US - the government (Treasury) issues the coins. But coins are only between 0.01% (one ten-thousandth) and 0.1% (one-thousandth) of the total money supply (the deposit account money supply plus the cash money supply). It varies by country and currency system, but banknotes are typically 2-5% of the total money supply. **

Commercial banks issue the deposit account money supply, which is 95-98% of the total money supply. Central banks issue the banknotes which are 2-5% of the total money supply. Coins - government-issued money - are an insignificant rounding error, in terms of the total money supply.]

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** [The percentage of US$ banknotes is higher because dollars are still the main international payments currency and people in other countries use US$ cash money alongside their national currencies. In many countries, you can spend US$ in stores and restaurants; whereas you cannot spend Costa Rican colones or Russian rubles in the US, because US merchants do not accept payment in these "foreign" currencies. Much of the global "illegal" activity is conducted using US$100 banknotes. The exact figure is unknown, but half or more of all US$ banknotes exist outside the geographical USA. These "offshore" US$ banknotes become part of these other countries' cash money supplies.]